Ask Creditnet: Pay Off Credit Cards vs. Installment Loan

Dear Creditnet: Will it be better for my credit scores if I pay down my credit card debt (I have about $8000 in balances) or pay off an installment loan of $10,000? I am looking to buy a home in the next year and I need to improve my credit score about 50 points. - Pete from GA

Answer: Pay off your credit card balances as soon as possible. It's not only the best choice for your credit scores, but it's usually the choice that will save you the most in interest charges as well. While I'm not sure what the interest rate is on your installment loan, I think it's probably safe to assume that it's lower than the interest rates your credit cards carry. If this is true, then you'll want to focus on completely paying off the credit card debt before reallocating any of your debt payments to the installment loan.

Of course, be sure to continue making at least the minimum payment on the installment loan until the credit cards are paid off and you're ready to begin tackling the installment loan principal. Keeping your payment history pristine is the most important factor in your credit scores! In addition, paying off the $6,000 in revolving debt should have a dramatic and positive effect on your FICO credit scores. The FICO credit-scoring model heavily weighs the percentage of available credit you use from all cards combined. The technical term for this is "credit utilization", and it accounts for about 30 percent of your FICO score. Keep in mind that consumers with the best credit scores tend to have credit utilization ratios around 10% or less.

Choosing to pay off the installment loan instead of your credit cards probably won't help your credit scores that much, and in some cases it could even hurt your FICO scores. This has been known to happen when a consumer's credit mix is affected after a home or auto loan is paid off. And since installment loans aren't included in your overall credit utilization ratio anyway (only revolving credit is included), paying down the loan balance just won't have the dramatic effect on your credit scores that can be seen when revolving debt is paid off. Now, the question that remains is will paying down your credit card balances increase your scores at least 50 points?

It's impossible to say for sure given the information I have here, but I think you have an excellent chance of experiencing a 50-point increase or more if you can reduce your credit utilization ratio below 10 percent. Good luck!

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Joshua Heckathorn was the President and owner of Creditnet.com. He shared his unique insights about credit cards, credit scores, investments, and all aspects of personal finance on Creditnet's blog, Credit¢ents. Joshua received a Bachelor of Science in Management (Finance) from Brigham Young University's Marriott School of Business and earned his Master of Business Administration from Seattle University in 2009.